In a letter to the SEC, the hedge fund industry urged the Commission to align the advertising regulations in the Investment Advisers Act with the Jumpstart Our Business Startups (JOBS) Act and ensure that private fund managers have greater clarity as to the types of information that they can provide to existing or potential investors. In the JOBS Act, Congress eliminated the general advertising and general solicitation restrictions of Regulation D, noted the Managed Funds Association, and expressed an intention to permit greater visibility of and transparency into entities, including hedge funds and other private funds, which offer and sell securities pursuant to revised Rule 506. The MFA also asked the SEC to extend the definition of accredited investor to knowledgeable employees of an investment company for purposes of the general solicitation provisions of Regulation D.
Section 201(a)(1) of the JOBS Act instructs the SEC to revise Rule 506 of Regulation D to eliminate the prohibition against general solicitation or general advertising for offers and sales of securities, provided that all purchasers are accredited investors. An issuer relying on revised Rule 506 must take reasonable steps to verify that purchasers are accredited investors. In addition, Section 201(b) amends Section 4 of the Securities Act to provide that offers and sales exempt under revised Rule 506 will not be deemed public offerings under the federal securities laws as a result of general advertising or solicitation.
In light of the elimination of the ban on general advertising for offers and sales made pursuant to revised Rule 506, the MFA believes that greater guidance and flexibility is necessary as to the types of information that registered or exempt private fund managers can provide in advertisements to investors. Although the SEC and its staff have provided guidance on various advertising limitations in Section 206 and Rule 206(4)-1 of the Advisers Act, uncertainty remains as to the scope and application of these limitations to hedge fund advisers.
Moreover, since the intent of these restrictions was to address investor protection concerns related to adviser advertisements provided to retail investors, the MFA believe that in the context of hedge and private fund advisers providing their advertisements solely to sophisticated investors, the current SEC no-action letter and legal guidance is counterproductive to this investor protection goal in that it makes it harder for private fund advisers to communicate effectively with their investors.
Therefore, the MFA believes it is consistent with Congressional intent and the protection of private fund investors to permit greater disclosure of information related to registered or exempt private fund managers in advertising materials; provided that such information remains subject to the anti-fraud provisions.
Knowledgeable Employees of Private Funds
The JOBS Act is designed to permit general solicitation and advertising in connection with offers and sales under Rule 506 as long as all purchasers are sophisticated investors. In light of this policy objective, the MFA urged the SEC to adopt regulations that include in the definition of accredited investor an additional category of investor, a knowledgeable employee under the Investment Company Act, that Congress has determined possesses the requisite knowledge and sophistication to purchase interests in private funds.
In the National Securities Markets Improvement Act, Congress directed the SEC to adopt rules to permit the ownership of securities by knowledgeable employees of a 3(c)(1) fund or 3(c)(7) fund. A fund may rely on Section 3(c)(1) of the Investment Company Act if its outstanding securities are beneficially owned by not more than 100 persons and it is not making and does not propose to make a public offering of its securities. A fund may rely on Section 3(c)(7) if its outstanding securities are owned exclusively by qualified purchasers, and it is not making and does not propose to make a public offering.
In 1997, the SEC adopted Rule 3c-5 under the Investment Company Act to define the term “knowledgeable employee” to include two categories of employees of a private fund or its affiliated investment manager: (i) any person who is an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, and (ii) employees who, in connection with their regular duties, participate in the investment activities of the 3(c)(1) or 3(c)(7) fund, other private funds, or certain other investment companies. Pursuant to Rule 3c-5 and interpretive guidance issued by the SEC staff, many employees of hedge fund managers who are knowledgeable employees own interests in a 3(c)(1) or 3(c)(7) fund for which they perform investment functions.
In the case of a 3(c)(7) fund, these employees are permitted to invest in the fund notwithstanding the wealth requirement in the definition of qualified purchaser, which is substantially higher than the comparable requirement in the definition of accredited investor. Some of these knowledgeable employees, such as those who have been recently hired by a fund manager, do not qualify as accredited investors.
In the MFA’s view, it would be inconsistent to effectively prohibit these employees from investing in private funds as a result of the accredited investor standard when Congress has explicitly determined that they may invest in private funds available only to investors that meet the higher qualified purchaser standard. The hedge fund group emphasized that this long-standing policy of permitting knowledgeable employees of an investment manager to invest in a private fund is critical to meeting the demands of institutional investors, which seek to have their interests aligned with the interests of the fund’s principals and the employees of the fund’s manager.
A primary method of achieving this alignment of interests is by permitting investment manager employees to make investments in funds they advise along with the investors. The MFA said it would be disruptive to private funds and their investors if a manager were no longer able to permit certain of its employees who participate in the investment activities of the fund to own interests in the fund.Since knowledgeable employees of a private fund manager have an equivalent level of sophistication and financial wherewithal as accredited investors, and are therefore of the type that Congress intends to be eligible to purchase interests in offerings conducted pursuant to revised Rule 506, the MFA urged the SEC to amend the definition of accredited investor to include those individuals who meet the definition of knowledgeable employee in Rule 3c-5 under the Investment Company Act. In that regard, the MFA noted that Section 413 of the Dodd-Frank Act authorized the Commission to amend the definition of accredited investor, other than the net worth threshold.